photo courtesy 401(k)calculator(dot)org
Popular wisdom has it that optimism lowers your blood pressure. So for our health, perhaps we ought to be grateful that it looks like the Securities and Exchange Commission’s new rules on money market funds will be less destructive than they might have been.
Of course, a pessimist would point out that we would be better off if the rules were not pointless or destructive at all. But we may need to take what we can get.
A couple of years ago, I described the rule changes being contemplated by the SEC’s then-Chairman, Mary Schapiro. Among other regulations, Schapiro would have required all money market funds to vary their share prices, or net asset values, virtually defeating the purpose for which such funds are commonly used. The argument went that making investors keep track of fluctuations would remind them that, while money market funds were virtually the same as cash, they were not identical, nor were they backed with federal protection like bank accounts. Meanwhile, those using such funds as checking or savings accounts would face the prospect of a burdensome tax reporting requirement, while funds would pass along the increased administrative burden in the form of higher fees. I predicted that if such regulations passed, money market funds would become virtually indistinguishable from short-term bond funds.
Despite the support of the Federal Reserve Chairman at the time, Ben Bernanke, Schapiro did not succeed in killing money market funds with her regulations designed to save them. Three commissioners formed a majority to overrule her in 2012. However, while the particular regulations at issue were set aside, the idea that money market funds still needed further reform persisted.
Now, more through luck than through good sense, the forthcoming push for money market fund reform (even in the absence of evidence that anything needs to be done) is at least less harmful than the previous plan, if The Wall Street Journal’s recent outline of the forthcoming rules is correct.
Under the rules as described, funds catering to small investors will not have to change the way they do business at all. That’s important, because such funds survive in this repressed interest rate era only with the financial support of their sponsoring companies, which typically are large brokerage or mutual fund firms that need to give investors a place to park cash between making other investments. Such retail funds are saddled with the high costs of servicing large numbers of relatively small accounts. Historically, money market funds could cover these costs out of the interest earned on the funds’ short-term investments, but since short-term investments have paid virtually no interest for the past six years thanks to the Fed, the funds are at best a break-even proposition.
Of course, the Fed doesn’t see itself as the problem. It sees money funds, which are a significant corner of the financial system that it does not directly control, as the problem. Hence its push for the SEC to do something. Bernanke’s successor, Janet Yellen, has described the pace of implementing more restrictive rules for short-term funding markets, including money market funds, as “at times […] frustratingly slow.”
Partly as a result of pressure from the Fed, the SEC still wants to impose the much-discussed floating share price - but only on money market funds that cater to institutional-sized clients. Since those floating prices would impose potentially lethal tax complexities, however, it appears that the move is contingent on the Treasury agreeing to unilaterally rewrite the tax rules, probably by permitting or imposing a “de minimis” provision to allow - or require - taxpayers to disregard money fund price movements that fall within a certain range.
Of course, once you declare that price movements are de minimis, you encourage people to ignore them. The whole point of the floating-price requirement, according to its supporters, is to remind investors that money funds aren’t the same as cash. This despite the fact that investors, unlike regulators, are unlikely to have been so short-sighted as to have forgotten. Tax leniency would undo the supposed logic behind the change, but it would make the change tolerable for investors.
But there’s a trap here, too. A de minimis option would be favorable to investors. A de minimis rule, which would disallow all money fund losses for tax purposes if they fell within a certain range, is a sucker’s bet. With interest rates already at rock bottom, the only direction money fund values can move is downward when rates inevitably rise. So the Treasury would graciously forego taxes on forthcoming gains, which are mathematically impossible, while disallowing investors the tax benefit of losses, which are much more likely to happen in the real world.
Money funds and their fixed $1-per-share price have been in wide use for about 35 years. They have never been a problem, in and of themselves. In the rare, exceptional case of the Prime Reserve Fund, which failed during the financial crisis, the precipitating cause was the federal government’s policy about-face in allowing Lehman Brothers to abruptly collapse. The resulting panic caused the government to step in to backstop the rest of the fund industry - but, as it turned out, the backstop existed only in name, partly because of the way the funds were designed. No federal money was needed because the funds are intrinsically safe, since they are widely diversified and invested only in short-term holdings.
The Journal also reported that the new rules will allow funds to impose exit restrictions in the event of another panic. That change is not a deal-breaker for most investors. Mutual funds have historically had the right to impose delays on redemptions during periods of market turmoil, and money funds are just a variety of mutual funds.
But note that the restrictions would only apply to funds that invest in private-sector debt obligations. Government regulators continue to maintain the conceit that government-issued securities are safer than private-sector ones. Tell that to holders of Detroit city bonds. This distinction alone is all the proof we need that the new rules serve a political, rather than economic, purpose.
So the new money market fund rules, as outlined, will still be pointless and destructive - but not nearly as much as they might have been. Let’s choose to be grateful.